By Alen Mattich

The consistency with which it has erred on the side of too much inflation during recent years has fed suspicions the Bank of England has de facto abandoned its 2% inflation target, with the complicity of U.K. Treasury chief George Osborne.

Is there any evidence for this, though? Possibly.

To begin with, the bank’s inflation projections have systematically underestimated inflation for years. The bank’s inflation report from February 2010 was most egregious. It showed the bank was expecting inflation to drop from around 3% to less than 1% by the end of the same year. Instead, inflation rose, hitting 3.7% by December.

More recently, the bank’s November Inflation Report expected inflation to peak at around 3.5% this spring. Its latest projections are for a peak of nearly 5%.

Although they’ve been getting worse, the outruns have been consistently one-sided for years, during which time the bank seems to have persisted with its models.

Associated Press

BoE Governor, Mervyn King

More importantly, though, in all of his comments during recent years, BOE governor Mervyn King, has argued strongly that to have achieved target inflation, the Bank would have to allowed deeper declines in household real earnings. This, in effect, translates to higher unemployment levels.

These unemployment levels would have been unacceptable and therefore the bank was right to pursue the policy it did, runs King’s argument.

This seems to offer an insight into what may effectively be the new target the bank, unofficially, tracks: nominal GDP. That’s to say, GDP with inflation factored back in.

King explicitly denies that the monetary policy committee is tracking nominal GDP. But he can’t do otherwise. The MPC has an explicit and quite clearly stated central target of 2% consumer price inflation, plus or minus one percentage point.

A look at the bank’s latest median projections for U.K. CPI and real GDP, on which it bases its policy-making decisions, shows that bulges in inflation projections over a period of a year have tended to accompany declines in real GDP growth, and vice-versa, hinting at a nominal GDP target of around 5% or slightly higher.

Some academic economists are strongly supportive of nominal GDP targeting — allowing inflation to run too hot at a time when real GDP is growing too slowly and then tightening after the rate of nominal growth exceeds a certain level, once previous shortfalls in nominal growth have been made up.

For now, the market seems content to ignore the BOE’s consistent and one-sided mistakes. This may be due to the fact that gilts are closely tracking international rather than domestic developments, particularly movements in U.S. Treasurys.

Eventually, though, investors’ attention will return to what’s happening in the U.K. They may not be so happy with the low interest rates they’ve accepted for years if they start to feel that the Bank of England’s real policy is nominal GDP targeting.

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